Stock Buybacks versus Dividends

There was an article written by Jennifer Openshaw last week on entitled Three Reasons to Prefer Dividends Over Buybacks. A lot of people agree with that opinion, namely that dividends are cash in your pocket, which is preferable to a stock buyback. However, I’m not so sure I personally prefer a dividend payment. Let me explain why by playing devil’s advocate for the three reasons cited in Jennifer’s article.

1) “Dividends are taxed at a rate not exceeding 15% while a capital gain may be taxed at ordinary rates if the stock is sold within a year. And if you wait more than a year, who knows what the tax law will be? So the dividend, at least for now, locks in the lower rate.”

I can think of a few different scenarios and only one of them results in the dividend being the better alternative from a tax perspective. If you own the stock in a retirement plan, tax rates are irrelevant. If we are talking about a taxable account, a dividend payment triggers a taxable event, meaning you pay the 15% tax on the dividend payment in the year you receive it, regardless of whether you sold the stock or not. Buybacks don’t trigger taxes.

The argument that the tax law could change in the future, therefore you should lock in a low rate, is a poor one. Typically when capital gains rates change, they are not retroactive. If you bought a stock in 2005 and the long term capital gains tax rate goes up in 2010, you don’t get stuck paying the higher rate when you sell the stock when the law was different.

In my view, the only time dividends are more beneficial from a tax perspective is when you hold a stock in a taxable account and you sell it in less than 12 months. I would argue this occurs less often than not. Most traders don’t rely on dividend paying stocks. Long term investors are more likely to have high levels of dividend income. Also, many investors have the bulk of their investments in tax-sheltered accounts.

2) “You can’t cash in on an announcement. there is no guarantee that the buyback will happen.”

I think this argument is weaker than the first one. The article is supposedly comparing dividends to stock buybacks, not dividends to stock buyback announcements. Obviously, given the choice between a dividend payment and a buyback announcement that doesn’t happen, you would take the dividend. If you are going to compare dividends and buybacks, I think you have to simply assume you are comparing a $1 paid out to shareholders with a $1 used to repurchase shares.

A lot of buyback opponents will throw out the argument that some buybacks are announced and never implemented, but the vast majority of buybacks are actually completed, not just announced and then thrown under the rug. If you are debating which use of cash is better, I think you need to assume the announced dividends get paid and the announced buybacks are implemented.

3) “A buyback accomplishes nothing if the company is granting just as many shares on the back end for options.”

This one is simply untrue. Assume you have two companies, all else equal, except one issues 1 million options per year without a buyback program and the other company issues the same 1 million options per year but also buys back 1 million shares in the open market with available free cash flow. Did the second company accomplish anything? Absolutely!

Stock buybacks are accretive to earnings per share, regardless of whether or not the company issues options or not, simply because buying back stock is better than not buying back stock. A company’s earnings per share will always be higher if they buy back stock compared to if they don’t. How many options the company issues to employees, if any, makes no difference. Of course, the higher the repurchased share to issued options ratio, the better off investors will be.

For the most part, I don’t think the reasons to prefer dividends cited in this particular article are very compelling. If you are seeking income from your stock portfolio, clearly you would prefer dividends. Other than that, I think share buybacks in many cases are just as good as dividends. In fact, if you are a long term investor in a taxable account, I would prefer a buyback because it postpones the payment of taxes. Anytime you can postpone paying someone something, especially the federal government, the time value of money is working in your favor.

So which do you prefer? A dollar of a company’s free cash flow paid out to you or used to increase your ownership percentage of the company?

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6 Thoughts on “Stock Buybacks versus Dividends

  1. Zach on June 18, 2007 at 2:31 PM said:

    I have a very hard time with journalists who want to make a logical argument “dividends are better than buybacks” and then distort the argument by not comparing apples to apples. Thanks for pointing out the inconsistencies for your readers. It’s too bad many people will read these type of articles and accept the authors opinions without realizing the argument was full of holes.

  2. Chad Brand on June 18, 2007 at 2:38 PM said:

    Exactly right, Zach. We can’t catch all the bad information out there, but educating people about some of it is important, and one of the goals of this blog. As you point out, oftentimes people will read something from someone who should know more than them, and therefore they simply accept what is said as fact without trying to poke holes in the argument that was presented.

  3. Anonymous on June 19, 2007 at 7:49 PM said:

    Dividends are better than buybacks because they put money in your pocket. If a company buys back its own shares, but its balance sheet looks worse because it has less cash, others will sell the stock and it will fall to a lower level. Stockholders who hold their shares end up poorer because of the buyback, not richer.

    If a company pays dividends to shareholders, the shareholders have cash in their pockets and are enriched even if they continue to hold the stock.

    Unless a company is legitimately undervalued, stock buybacks are one of the most foolish ways that corporations squander shareholder value.

  4. Chad Brand on June 19, 2007 at 9:05 PM said:

    The counter argument to that pro-dividend stance would go something like this:

    1) Cash on the balance sheet will go down with both dividends and buybacks. The money is used either to buy shares or pay shareholders, but the same amount of cash is used in both cases.

    2) Buybacks are accretive to earnings per share. They give shareholders a higher ownership percentage in the company. This would not make them poorer.

    3) Many people reinvest dividends they receive. This has the same effect as a buyback (instead of reducing share count to boost your percentage ownership, you buy more shares to boost your ownership). When reinvesting dividends, you trigger a taxable event, but with a buyback you don’t owe any taxes and get the same benefit.

    4) Using cash in a way that is accretive to earnings seems to me to be a great way to enhance shareholder value, not squander it.

  5. Trader@Work on June 22, 2007 at 12:25 PM said:

    Warren Buffett called it “Asset Allocation”. Dividend and share buy back are very similar but it all depends on the management to think and act rationally. They should buy back share if the stock price is really cheap (compare to a conservative valuation), invest in the business for growth, else return the cash to the share holder.

    Look at Bank of America, dividend increase 11.8 fold in 21 years. Those excess cash unless can be deployed in higher return asset, it should pay out as dividend.

    But, lets see why dividend is better because

    1. With dividend, the EXCESS cash is taken out of the management hand now and they won’t able to do dump thing like buy another company that is not profitable as itself. They need to think or work harder to grow the business. They are just human, if you let them have too much cash, they work less and get lazy.

    2. When the dividend paying is became a ‘culture’ (think all the banks), the management will hesitate to waste any cash they have. Think if all the previous CEOs keep the cash no dividend and didn’t do much buy back because the stock price is too high. The next CEO come in, see all the cash sit around will be more than happy to announce a share buy back regardless of the share price. Benefit himself and next quarter wallstreet will see a jump in earning…

    3. The investors may have other investment that is more promising than the current company, 15% tax yes, we feel the pain but if you talk about another long term investment (think 10 years), 15% is nothing, again think all the public service you are getting. (except funding the war, let’s leave that part out here)

    So, instead of depending the management to think rationally, dividend put money in share holder pocket. Look at all the coporate acqusitions, Boston scientifics buy Guident. Ebay bought Skype. Skype? A (almost) free online chat company. Talk about irrational thinking.

  6. Chad Brand on June 22, 2007 at 12:36 PM said:

    This is a good point. If you don’t trust management to spend the money wisely, then you would prefer they pay you directly via dividends. I would put buybacks in the category of a wise investment, but poor acquisitions do happen frequently and can be very bad, if not disasterous.

    I would just add that you probably should not own stock in companies where you don’t trust the management, unless you have reason to believe they can’t hurt you.

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